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The virtually simultaenous bankruptcies of The Sharper Image and Lillian Vernon shouldn’t have surprised anyone.

The rules of the game have changed. It started with merchandising. Once the merchandise in these catalogs went stale, both companies entered a dangerous spiral, losing demand per book while driving up marketing cost as a percent of sales. Once demand started to decline, the only lever left was price and reduced marketing costs, both of which lowered gross margins.

Starving Margins

Gross margins are more important this year than in the past because the Internet has flattened competition among retailers, making the marketplace more efficient every year. No longer can you sell me-too products for 10 cents more than the business down the street. So margins have become compressed for look-alike competitors.

Last holiday season, competition was fierce for meager sales growth. That meant markdowns, free shipping offers and other sales promotions to drive growth. As a result, margins were further compressed. And that’s precisely why gross margins are even more important this year.

“The Internet is driving gross margins down for people that haven’t made their product unique,” says David Solomon, co-CEO of New York-based investment bank Lazard Middle Market. “Unless you have a very special business model, you’re going to have a hard time growing in this crowded Internet space.”

Think of margins as money for your company. Gross margin is a company’s total sales revenue minus cost of goods sold, divided by the total sales revenue, expressed as a percentage. The higher this percentage, the more the company retains on each sales dollar to service its other costs.

Multichannel marketing is a margin-driven business. Improve the margin by 1 percent, and that contributes directly to overhead and profit. Lose a point, and it affects the bottom line. Depending on the product line, marketers have gross margins between 40 percent to 80 percent. Most multichannel companies are in the 55 percent to 60 percent range.

The 5 Cs

Lazard’s Solomon offers up just the tonic to improve your margins: The 5 Cs.

COMMUNITY: “People are looking for their corner store again,” he says. “In this fragmented, mass culture, people want to reconnect with like-minded people — even though they might be 5,000 miles away.”

CONTENT: Retailers used to provide information and expertise, but no longer, Solomon points out. Products now sell themselves at Wal-Mart and online. But consumers still want expertise and advice. “The best retailers provide great, unbiased information,” he points out. This is precisely the strategy employed by entrepreneur Alex Tabibi and Pets United, the multichannel marketer that built its $80-million empire of common pet URLs and common community where pet owners can talk to each other.

COMMUNICATION: “The best online retailers engage in two-way communication with their customers,” Solomon notes. Blogs, e-mails and bulletin boards/chats allow two-way conversations. Some craft sites demonstrate how customers use their products. Others post customer product reviews.

CREATIVITY: ”Product innovation is the heart and soul of merchandising in a differentiated [noncommodity] strategy,” he says. “Develop innovative, proprietary products so you don’t have to compete on price. Build your merchandise mix around a clear lifestyle.”

CREDIBILITY: Consumers want to know they are buying the right products that’ll deliver the proper functionality, and that’ve been accepted by others, Solomon points out. So the marketers must have credibility with consumers.

Hit products have delivered functionality and developed this social acceptance to become brands over time. So a retailer can sell existing brands, such as Zappos’ products, or develop its own brand. Zappos, for example, has become a credible brand that delivers on its promise.

It’s more powerful to develop your own brand over time, Solomon says, by delivering on its promise and gaining credibility with consumers. Credibility with many consumers will generate word-of-mouth referrals and ultimately build the brand.

Is Maximizing Minimizing?

With Sharper Image and Lillian Vernon, Solomon believes once-great merchandisers grew stale by focusing on incremental optimization of SKU mix, maximizing contribution per square inch in the short term. The method lost merchandising flair and excitement over time, however — it became stale. “It reminds me of the old Figi’s gift food baskets,” Solomon recalls. “They’d replace the salami and cheese basket spread with the salami, cheese and nuts spread because it had a 2 percent increase in contribution per inch. But they completely missed the big trend: Salami and cheese were no longer a gourmet treat to send to your friends.”

Marketers need to differentiate and find a high-demand product mix. Stale, unresponsive merchandisers will suffer in this environment, but many startups with creative ideas will flourish. There’s going to be a dynamic, swirling competition where only the best marketers survive in an accelerating cycle of innovation. As Solomon says, “The Internet is at once a greenhouse of innovation and a ruthless, unforgiving wilderness.”

Make no mistake, the rules have changed. Lillian Vernon and The Sharper Image have taught us that you can’t do it the same old way anymore. «

Freelance writer Mark Del Franco has covered multichannel mergers and valuations for a decade. You can reach him at mark.delfranco@yahoo.com.